Microeconomics

Session 5-7

THE TECHNOLOGY OF PRODUCTION

factors of production Inputs into the production process (e.g., labor, capital, and materials). The Production Function

q F (K , L)
production function Function showing the highest output that a firm can produce for every specified combination of inputs.
Inputs and outputs are flows. Above equation applies to a given technology. Production functions describe what is technically feasible when the firm operates efficiently.

In the long run the pessimist may be proved right, but the optimist has a better time on the trip.
The Short Run versus the Long Run
short run Period of time in which quantities of one or more production factors cannot be changed.

fixed input be varied.

long run

Production factor that cannot

Amount of time needed to make all production inputs variable.

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

average product

Output per unit of a particular input.

marginal product

Additional output produced as an input is increased by one unit.

Average product of labor = Output/labor input = q/L

Marginal product of labor = Change in output/change in labor input = q/L

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

TABLE 6.1 Production with One Variable Input

Amount of Labor 0 (L) Amount of Capital 10 (K) Total Output 0 (q) Average Product (q/L) Marginal (q/L) Product

1 2 3

10 10 10

10 30 60

10 15 20

10 20 30

4
5 6 7

10
10 10 10

80
95 108 112

20
19 18 16

20
15 13 4

8
9 10

10
10 10

112
108 100

14
12 10

0
4 8

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

The Slopes of the Product Curve
Figure 6.1 Production with One Variable Input

The total product curve in (a) shows the output produced for different amounts of labor input. The average and marginal products in (b) can be obtained (using the data in Table 6.1) from the total product curve. At point A in (a), the marginal product is 20 because the tangent to the total product curve has a slope of 20. At point B in (a) the average product of labor is 20, which is the slope of the line from the origin to B. The average product of labor at point C in (a) is given by the slope of the line 0C.

 Average Product diminishes after the point where, Marginal Product = Average Product.
Why?

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

The Law of Diminishing Marginal Returns

As the use of an input increases with other inputs fixed, the

resulting additions to output will eventually decrease.

Figure 6.2 The Effect of Technological Improvement

Labor productivity (output per unit of labor) can increase if there are improvements in technology, even though any given production process exhibits diminishing returns to labor. As we move from point A on curve O1 to B on curve O2 to C on curve O3 over time, labor productivity increases.

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

The law of diminishing marginal returns was central to the thinking of political economist Thomas Malthus (17661834). Malthus believed that the worlds limited amount of land would not be able to supply enough food as the population grew. He predicted that as both the marginal and average productivity of labor fell and there were more mouths to feed, mass hunger and starvation would result.

Fortunately, Malthus was wrong (although he was right about the diminishing marginal returns to labor).

PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

Figure 6.3 Cereal Yields and the World Price of Food

Cereal yields have increased. The average world price of food increased temporarily in the early 1970s but has declined since.

Next: B.S. Minhas

PRODUCTION WITH TWO VARIABLE INPUTS

Figure 6.8 Isoquant Describing the Production of Wheat

A wheat output of 13,800 bushels per year can be produced with different combinations of labor and capital. The more capital-intensive production process is shown as point A, the more labor- intensive process as point B. The marginal rate of technical substitution between A and B is 10/260 = 0.04.

TABLE 6.4 Production with Two Variable Inputs Capital Input 1 2 3 4 5

1 20 40 55 65 75

2 40 60 75 85 90

3 55 75 90 100 105

4 65 85 100 110 115

5 75 90 105 115 120

PRODUCTION WITH TWO VARIABLE INPUTS Isoquants

isoquant Curve showing

all possible combinations of inputs that yield the same output.

PRODUCTION WITH TWO VARIABLE INPUTS Isoquants isoquant map

Figure 6.4
Production with Two Variable Inputs

Graph combining a number of isoquants, used to describe a production function.

A set of isoquants, or isoquant map, describes the firms production function. Output increases as we move from isoquant q1 (at which 55 units per year are produced at points such as A and D), to isoquant q2 (75 units per year at points such as B) and to isoquant q3 (90 units per year at points such as C and E).

PRODUCTION WITH TWO VARIABLE INPUTS Diminishing Marginal Returns

Holding the amount of capital fixed at a particular levelsay 3, we can see that each additional unit of labor generates less and less additional output.

PRODUCTION WITH TWO VARIABLE INPUTS Substitution Among Inputs marginal rate of technical substitution (MRTS) Amount by
which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant.
Figure 6.5 Marginal Rate of Technical Substitution

MRTS = Change in capital input/change in labor input = K/L (for a fixed level of q)

Isoquants are downward sloping and convex. The slope of the isoquant at any point measures the marginal rate of technical substitutionthe ability of the firm to replace capital with labor while maintaining the same level of output. On isoquant q2, the MRTS falls from 2 to 1 to 2/3 to 1/3.

(MP ) / (MP ) (K / L) MRTS (6.2) L K

Illustration of an Isoquant
Production function: Q = K1/2 L1/2 A standard Cobb-Douglas production function
If K = 40 and L = 10, Q = 20 If K = 10 and L = 40, Q = 20 Both points are in the same isoquant.

Marginal Productivity
What is MPL at (K = 40, L=10)? Q(40, 10) = 20 and Q(40, 10+1) = 20.98 The marginal contribution of last unit of labor is 0.98 It is the value of is MPL at (K = 40, L=10). Similarly, MPK at (K = 40, L=10) = Q(40 + 1, 10) Q(40, 10) = 0.25

Marginal Rate of Technological Substitution (MRTS)

Both (K = 40, L=10) and (K = 36.36 and L = 11) are in the isoquant. MRTS = - K/L = -(36.36-40)/(11-10) = 3.64 It is Close to MPL/ MPK = 0.98/0.25 = 3.92

MPL at (K = 10, L=40) = Q(10, 40+1) - Q(10, 40) = 0.25 MPK at (K = 10, L=40) = Q(10 + 1, 40) Q(10, 40) = 0.98 MRTS - K/L = -(9.76-10)/(41-40)= 0.24 MPL/ MPK = 0.25

MPL = K1/2 L-1/2 = (K/L)1/2. Clearly, MPL declines as L increases. MPK = K-1/2 L1/2 = (L/K)1/2. MPK declines as K increases.

MRTS Falls as we move from left to right.

PRODUCTION WITH TWO VARIABLE INPUTS

Production FunctionsTwo Special Cases

Figure 6.6

Isoquants When Inputs Are Perfect Substitutes

When the isoquants are straight lines, the MRTS is constant. Thus the rate at which capital and labor can be substituted for each other is the same no matter what level of inputs is being used. Points A, B, and C represent three different capital-labor combinations that generate the same output q3.

PRODUCTION WITH TWO VARIABLE INPUTS

Production FunctionsTwo Special Cases fixed-proportions production function Production function with L-shaped isoquants, so that only one combination of labor and capital can be used to produce each level of output. The fixed-proportions production function describes situations in which methods of production are limited.
Figure 6.7

Fixed-Proportions Production Function

When the isoquants are Lshaped, only one combination of labor and capital can be used to produce a given output (as at point A on isoquant q1, point B on isoquant q2, and point C on isoquant q3). Adding more labor alone does not increase output, nor does adding more capital alone.

RETURNS TO SCALE
returns to scale Rate at which output changes as inputs
are changed proportionately.

increasing returns to scale

Situation in which output increases more than proportionately when all inputs are increased in a certain proportion. Situation in which output changes in the same proportion as the change in inputs. Situation in which output increases less than proportionately when all inputs are increased in a certain proportion.

constant returns to scale

decreasing returns to scale

Returns To Scale * To Change

Increasing returns to scale: If for all >1, and for all x1,,xn F(x1,, xn) > F(x1,,xn) Decreasing returns to scale: If for all >1, and for all x1,,xn F(x1,, xn) < F(x1,,xn) Constant returns to scale: If for all > 0, and for all x1,,xn F(x1,, xn) = F(x1,,xn)

RETURNS TO SCALE
Describing Returns to Scale
Figure 6.9 Returns to Scale

When a firms production process exhibits constant returns to scale as shown by a movement along line 0A in part (a), the isoquants are equally spaced as output increases proportionally.

However, when there are increasing returns to scale as shown in (b), the isoquants move closer together as inputs are increased along the line.

Guns Versus Butter

Product Transformation Curves
Figure 7.10 Product Transformation Curve

The product transformation curve describes the different combinations of two outputs that can be produced with a fixed amount of production inputs. The product transformation curves O1 and O2 are bowed out (or concave) because there are economies of scope in production.

product transformation curve Curve showing the various combinations of two different outputs (products) that can be produced with a given set of inputs.

ECONOMIES OF SCOPE
Economies and Diseconomies of Scope
economies of scope Situation in which joint output of a single firm is greater than output that could be achieved by two different firms when each produces a single product.

diseconomies of scope Situation in which joint output of a single firm is less than could be achieved by separate firms when each produces a single product.

ECONOMIES OF SCOPE
The Degree of Economies of Scope
To measure the degree to which there are economies of scope, we should ask what percentage of the cost of production is saved when two (or more) products are produced jointly rather than individually.
(7.7)

degree of economies of scope (SC) Percentage of cost savings resulting when two or more products are produced jointly rather than Individually.

MEASURING COST: WHICH COSTS MATTER?

Economic Cost versus Accounting Cost accounting cost Actual expenses plus depreciation charges for capital equipment. economic cost Cost to a firm of utilizing economic resources in production, including opportunity cost. Opportunity Cost opportunity cost Cost associated with opportunities that are forgone when a firms resources are not put to their best alternative use.

MEASURING COST: WHICH COSTS MATTER?

Fixed Costs and Variable Costs

total cost (TC or C) Total economic cost of production, consisting of fixed and variable costs.
fixed cost (FC) Cost that does not vary with the level of output and that can be eliminated only by shutting down. variable cost (VC) as output varies. Cost that varies

The only way that a firm can eliminate its fixed costs is by shutting down.

MEASURING COST: WHICH COSTS MATTER?

sunk cost Expenditure that has been made and cannot be recovered. Because a sunk cost cannot be recovered, it should not influence the firms decisions.

For example, consider the purchase of specialized equipment for a plant. Suppose the equipment can be used to do only what it was originally designed for and cannot be converted for alternative use. The expenditure on this equipment is a sunk cost.
Because it has no alternative use, its opportunity cost is zero. Thus it should not be included as part of the firms economic costs.

The Chunnel A Really Sunk Cost

Chunnel is a tunnel under the English channel connecting England and France. The Initial (1987) estimate:
Cost 3 Billion Revenue 4 Billion

The Revised (1990) estimate:

Cost 4.5 Billion Already spend 2.5 Billion Revenue 4 Billion

MEASURING COST: WHICH COSTS MATTER?

Marginal and Average Cost Average Total Cost (ATC) average total cost (ATC) Firms total cost divided by its level of output. average fixed cost (AFC) Fixed cost divided by the level of output. average variable cost (AVC) Variable cost divided by the level of output.

MEASURING COST: WHICH COSTS MATTER?

Marginal and Average Cost Marginal Cost (MC) marginal cost (MC) Increase in cost resulting from the production of one extra unit of output. Because fixed cost does not change as the firms level of output changes, marginal cost is equal to the increase in variable cost or the increase in total cost that results from an extra unit of output. We can therefore write marginal cost as

A Production Process With Labour

Labo ur 1 2 Product ion Marginal Productivity Cost Marginal Cost 10 5 = (200100)/(3010) 3.33

10 30

10 20

100 200

60

30

300

4
5 6 7

80
95 108 112

20
15 13 4

400
500 600 700

5
6.67 7.70 25

Wage = 100 Rupees per Labour

Marginal Product of Labour and Marginal Cost

35 30 25

20 15 10 5 0
1 2 3 4 5 6 7

Marginal Product of Labour Marginal Cost

Marginal Cost Curve

The change in variable cost is the per-unit cost of the extra labor w times the amount of extra labor needed to produce the extra output L. Because VC = wL, it follows that

The extra labor needed to obtain an extra unit of output is L/q = 1/MPL. As a result,
(7.1)

Diminishing Marginal Returns and Marginal Cost Diminishing marginal returns means that the marginal product of labor declines as the quantity of labor employed increases. As a result, when there are diminishing marginal returns, marginal cost will increase as output increases.

COST IN THE SHORT RUN

The Shapes of the Cost Curves
Figure 7.1 Cost Curves for a Firm

In (a) total cost TC is the vertical sum of fixed cost FC and variable cost VC. In (b) average total cost ATC is the sum of average variable cost AVC and average fixed cost AFC. Marginal cost MC crosses the average variable cost and average total cost curves at their minimum points.

COST IN THE LONG RUN

The User Cost of Capital user cost of capital Annual cost of owning and using a capital asset, equal to economic depreciation plus forgone interest. The user cost of capital is given by the sum of the economic depreciation and the interest (i.e., the financial return) that could have been earned had the money been invested elsewhere. Formally,

We can also express the user cost of capital as a rate per dollar of capital:

COST IN THE LONG RUN

The Isocost Line isocost line Graph showing all possible combinations of labor and capital that can be purchased for a given total cost. To see what an isocost line looks like, recall that the total cost C of producing any particular output is given by the sum of the firms labor cost wL and its capital cost rK:
(7.2)

If we rewrite the total cost equation as an equation for a straight line, we get

It follows that the isocost line has a slope of K/L = (w/r), which is the ratio of the wage rate to the rental cost of capital.

COST IN THE LONG RUN

The Isocost Line
Figure 7.3 Producing a Given Output at Minimum Cost

Isocost curves describe the combination of inputs to production that cost the same amount to the firm. Isocost curve C1 is tangent to isoquant q1 at A and shows that output q1 can be produced at minimum cost with labor input L1 and capital input K1. Other input combinations L2, K2 and L3, K3yield the same output but at higher cost.

All three problems

COST IN THE LONG RUN

Choosing Inputs Recall that in our analysis of production technology, we showed that the marginal rate of technical substitution of labor for capital (MRTS) is the negative of the slope of the isoquant and is equal to the ratio of the marginal products of labor and capital:
(7.3)

It follows that when a firm minimizes the cost of producing a particular output, the following condition holds:

We can rewrite this condition slightly as follows:

(7.4)

COST IN THE LONG RUN

Cost Minimization with Varying Output Levels expansion path Curve passing through points of tangency between a firms isocost lines and its isoquants.

The Expansion Path and Long-Run Costs

To move from the expansion path to the cost curve, we follow three steps:
1. Choose an output level represented by an isoquant. Then find the point of tangency of that isoquant with an isocost line.

2. From the chosen isocost line determine the minimum cost of producing the output level that has been selected.
3. Graph the output-cost combination.

COST IN THE LONG RUN

Cost Minimization with Varying Output Levels
Figure 7.6 A Firms Expansion Path and Long-Run Total Cost Curve

In (a), the expansion path (from the origin through points A, B, and C) illustrates the lowest-cost combinations of labor and capital that can be used to produce each level of output in the long run i.e., when both inputs to production can be varied. In (b), the corresponding longrun total cost curve (from the origin through points D, E, and F) measures the least cost of producing each level of output.

LONG-RUN VERSUS SHORT-RUN COST CURVES The Inflexibility of Short-Run Production

Figure 7.7 The Inflexibility of Short-Run Production

When a firm operates in the short run, its cost of production may not be minimized because of inflexibility in the use of capital inputs. Output is initially at level q1. In the short run, output q2 can be produced only by increasing labor from L1 to L3 because capital is fixed at K1. In the long run, the same output can be produced more cheaply by increasing labor from L1 to L2 and capital from K1 to K2.

LONG-RUN VERSUS SHORT-RUN COST CURVES Long-Run Average Cost long-run average cost curve (LAC) Curve relating average cost of production to output when all inputs, including capital, are variable. short-run average cost curve (SAC) Curve relating average cost of production to output when level of capital is fixed.

long-run marginal cost curve (LMC) Curve showing the change in long-run total cost as output is increased incrementally by 1 unit.

LONG-RUN VERSUS SHORT-RUN COST CURVES The Relationship Between Short-Run and Long-Run Cost
Figure 7.9 Long-Run Cost with Economies and Diseconomies of Scale

The long-run average cost curve LAC is the envelope of the short-run average cost curves SAC1, SAC2, and SAC3. With economies and diseconomies of scale, the minimum points of the shortrun average cost curves do not lie on the long-run average cost curve.